Thursday, June 25, 2009

This post is long overdue, for which I won’t apologise. Regime choice is a murky and extremely complex area that has bedeviled policymakers, multilateral institutions and the man on the street for many years, and I wasn’t particularly eager to begin this post.

Part of the problem is that while there are only three main categories of regime – fixed, floating, and intermediate – there are a large number of variations that could with justice be called categories of their own. A second issue that makes this topic difficult to cover is the difference between de jure and de facto regimes: as much as half the currencies in the world follow exchange rate regimes at odds with what they officially report. The IMF thus tracks 13 (!) different regime categories, with currency categories defined not by their reported regime but rather by the actual behavior of their exchange rates:

The choice of regime is not a cut and dried matter – what works for one country may not work for another. Also, what works at one point in time might not be an appropriate regime down the road. Some of the influences include the size of the country involved, its openness to trade and the relative size of the tradable sector, the structure of its trade (few or many trade partners), colonial ties, capital account openness, depth and breadth of the domestic money market etc. etc. etc.

Generally speaking, the larger and more developed a country and the deeper its financial markets, the more desirable it is to have a floating exchange rate regime. Which suggests the opposite is true – the smaller and less-developed a country, the more likely a fixed regime is the better choice, especially if trade is dominated by one counter-party and the capital account is relatively closed. These are gross generalizations, and there’s plenty of literature available for those who want to dig deeper.

The main criterion of regime choice is fairly clear though, at least for those countries integrated into the international financial system – it’s a choice between control over domestic monetary conditions or external prices. An exchange rate regime biased towards being fixed implies less control over interest rates and the money supply, and by extension domestic inflation and growth. A fixed exchange rate regime means a country can be at the mercy of policy decisions in the reserve currency country, which may be at odds with local monetary conditions. Conversely, a regime biased toward floating implies less control over the external price of tradables, which is important for commodity producers or small open economies, as well as suffer greater volatility in the exchange rate.

A regime choice in the middle therefore sometimes seems attractive – allowing for some degree of control over domestic monetary conditions, while also exercising some control over external prices. In practice however a intermediate regime is the worst possible choice as it means a constant balancing act between policy objectives: you can’t have your cake and eat it too. Under most circumstances, a soft peg regime combined with capital account liberalization has typically led to a financial crisis in developing countries – just as happened in East Asia in 1997-98 and in Mexico before that, and even in the European Exchange Rate Mechanism (ERM: the precursor to Euro monetary union). How so? Two main reasons why – divergent macro-policies, and capital flows.

The almost-collapse in the ERM is an interesting case, more so since it involved advanced economies. The currencies in the ERM were on fixed parity with the Deutschmark, with a small trading band to account for fluctuations. This was fine when all the countries had similar macro conditions and inflation rates. Then something momentous occurred – the Berlin wall came down, and Germany emerged as one nation. The reconstruction and integration effort required a massive dose of fiscal spending, which in turn ignited inflation. In response the BundesBank hiked interest rates, which of course meant that the DEM appreciated, and dragged the rest of the currencies in the ERM with it.

But some of the other ERM countries were already in the midst of an economic slowdown (particularly the UK), and needed lower not higher interest rates. This inconsistency in monetary policies meant that forex traders everywhere sold ERM currencies and bought DMK (with the notable and unfortunate exception of BNM), putting even more pressure on the ERM parities. This was a sure-fire, one-way bet – if the ERM held, then traders gained on the interest differential. If it didn’t, then massive profits could be made in the devalued currencies, which in fact occurred when GBP, NOK, SEK eventually pulled out of the ERM.

The East Asian case is different, but with similar results. The proximate causes was a secular inflow of portfolio and direct investment, and less well-known, a sharp devaluation of the Renminbi. This had two effects: on the one hand, the inflow of capital expanded domestic money supply while keeping exchange rates elevated, and on the other trade competitiveness was lost. Central banks were unable to fully sterilise the incoming money*, and banks responded by going on a lending spree. The resulting investment boom fed on itself, triggering current account deficits and incipient inflation, which necessitated raising interest rates and boosting exchange rates further. This in turn of course attracted even more capital, which resulted in economies overheating.

*BNM basically gave up in late 1995, coincidentally the same month Anwar Ibrahim became Finance Minister.

This is the point where inconsistency between pegged exchange rates and macro-conditions created a financial crisis. Higher inflation and current account deficits suggested these currencies needed to depreciate. The fact that returns on investment were also getting poorer also helped foster a lower valuation of these currencies, at odds with prevailing exchange rates. Much as in the case of the ERM, speculators were faced with a one-way, no-lose bet with predictable results.

Based on these experiences, bipolar solutions appear to be the best choices – at the very least hard pegs for developing countries, or at least managed floats for higher income countries. But many countries continue to run intermediate regimes with some success, primarily I think because their capital accounts are much less open.

This is really not option available to Malaysia with our degree of exposure to global trade and our aspirations for creating an international centre for Islamic banking. The current regime choice is appropriate in my view, especially since the policy instrument of choice is now short-term interbank rates. The financial sector is far deeper now than it was pre-1997, with better developed capital markets and the capacity to absorb larger capital flows.

Etheorist has issued a follow-up of his thoughts in his original post outlining his support for a stronger Ringgit level. My critique of his ideas are contained in this post, where my position is essentially that a stronger MYR level is fine provided it is consistent with changes in the economy, but not otherwise.

I find myself having problems with his new post as well. My main contentions are two-fold: first with reference to the central bank "engineering" an appreciation of the exchange rate, which has monetary implications, and second the likely impact on the economy of an artificial appreciation of the exchange rate from the Balassa-Samuelson based model I described before, which has real economy implications. I also have some different interpretations of economic developments of the past decade, but since this post is going to be long and a bit technical, I will deal with those in a following post.

First, to deal with the problem of engineering a non-secular appreciation of the exchange rate. To understand the issues here, one must first have an understanding of how a central bank influences the exchange rate above or below the market determined rate. Let's first examine the case of weakening the currency, since everyone appears to believe the stylized fact that the MYR is below its long term equilibrium level.

To achieve a lower exchange rate requires the central bank to sell domestic currency for foreign currency. On the central bank's balance sheet, this appears as an increase in international reserves (+assets), in exchange for depositing money in the banking system's accounts with the central bank (+liabilities). This results in an expansion of the money supply, which if unsterilised could trigger an undesired credit expansion and demand-fed inflation, exacerbated by the lower short term nominal interest rates from the monetary injection.

Sterilisation refers to central bank open market operations designed to keep interest rates and money supply stable in conjunction with central bank forex transactions. It’s similar to normal liquidity management operations in the sense that the mechanism is the same.

Since in this example a monetary injection was the result of the forex transaction, the central bank must drain liquidity from the interbank market. This is done by selling the central bank's holdings of securities to the banking system, enough to fully or partially offset the monetary injection. Since the central bank in our example is interested in weakening the exchange rate of the domestic currency, unsterilised intervention is also an option at the risk of higher inflation, but also with the potential benefit of higher economic growth.

Thus the practical limits of weakening the exchange rate are: what constitutes an acceptable level of higher inflation; or if sterilisation is resorted to, the borrowing capacity of the central bank. At least that's the case if you don't want to create another Zimbabwe – the central bank’s credibility in keeping the soundness of the domestic currency is at stake.

Strengthening a currency’s exchange rate over its market-determined rate operates in the opposite fashion: the central bank buys domestic currency in return for foreign exchange. This appears as a drop in international reserves on the asset side of the central bank’s balance sheet, and as a drop in the banking system’s cash balances with the central bank. This is also ipso facto a contraction in the money supply, and pushes up short term interest rates.

An engineered appreciation of the exchange rate is thus inherently deflationary, both in terms of the domestic money supply as well as in terms of import prices. If this is undesirable, for instance when inflation and growth are already too low or negative, the central bank can again resort to full or partial sterilization via a purchase of securities from the banking system, thereby injecting funds into the banking system.

From the above it’s easy to see the limits of artificially boosting the exchange rate level beyond the market clearing level: it is limited by the amount of international reserves at the central bank, as well as the supply of available securities in the banking system. This further implies that a strengthening operation is unlikely to succeed for long without a fairly deep supply of public debt.

In both weakening and strengthening operations, if the degree of misalignment in the target exchange rate is far enough away from the fundamental equilibrium rate, the central bank must continually intervene to maintain its target parity which puts it up against the limits of intervention that much faster. Note also that increasing or decreasing the amount of foreign currency in the system does not have any impact on the banking system’s capacity to lend, since loans can only be made to residents in domestic currency.

A second implication is that by virtue of targeting the exchange rate, volatility of either or both money supply and interest rates will become an order of magnitude greater, because the central bank cannot target all three. This is actually easy to see from the pre- and post-2005 Malaysian experience, where interest rates were higher and spreads far wider pre-2005.

A third implication is that artificially weakening the exchange rate is far easier than strengthening it, because of the nature of the limits imposed by the mechanisms employed. In extremis, a central bank can print money to fund forex purchases, which is not an option the other way around – the level of international reserves is a hard limit.

Are there ways around these limits though? For strengthening the exchange rate, yes there is – you can partially or fully close the capital account. But since this entails a general withdrawal from global financial integration, it also means closing access to foreign investment (particularly portfolio) as well as turning our backs on development. I’ll return to the topic of intervention and sterilisation in a future blog post.

A second less painful way around this is to simultaneously engineer an increase in the equilibrium rate. That ensures that misalignments between the equilibrium rate and the nominal rate aren’t too far apart. What are the elements that need to be pushed to achieve this objective? This leads me back to the Balassa-Samuelson Hypothesis model I described before.

To summarise, an economy can be divided into two producing sectors – tradables and non-tradables. Domestic prices (adjusted for the exchange rate) in the tradable sector are everywhere equalized internationally, since demand and supply are determined on a global basis. Domestic prices in the non-tradable sector however are determined purely by local conditions. Labour and capital are the production inputs, where the former is immobile but the latter fully mobile across international borders.

The effect on exchange rates can be described as follows: say for instance that there is an exogenous expansion in the non-tradable sector. This bids up wages across the whole economy, which reduces the relative productivity in the tradable sector. There is thus upward pressure on prices in the tradable sector. However, since prices in the tradable sector are set internationally, the end result is ceterus paribus an appreciation in the real exchange rate of the domestic currency to equate the international prices of tradables. Note that this effect arises from structural changes in the domestic economy rather than changes in international relative prices.

Now that we have that in mind, what’s the impact of an artificially raised exchange rate without these structural changes? An appreciation in the exchange rate creates an identical reduction in relative productivity for the tradable sector as in my example above. However, since there has been no corresponding increase in total domestic demand within the economy, the result is a reduction in the total demand for labour thus putting downward pressure on wages and prices in the tradable sector. This in turn will tend to depreciate the exchange rate. The net result is a tendency to revert to the equilibrium exchange rate, but with higher unemployment.

The opposite is true of an artificially weakened exchange rate. You get an increase in relative productivity of the tradable sector, which has the effect of putting upward pressure on prices and wages in the tradable sector since total demand is also higher. This will have the effect of putting upward pressure on the exchange rate, with the net result a return towards the equilibrium rate but with higher employment.

In short, exchange rate appreciation above the equilibrium level, as a policy tool, won’t result in a rise in incomes but rather the reverse. If I can resort to that hoary old chestnut phrase, “correlation does not imply causality”. In this case, one must distinguish between productivity in the non-tradable sector which is not subject to international competition, and productivity in the tradable sector which is subject to international price pressures. An increase in the former results in a depreciating exchange rate, while for the latter the opposite is true.

Tuesday, June 23, 2009

[Update 09 August 2010: This post has been deprecated. I’m maintaining a permanent page for everybody’s reference with updated links here]

I’ve noticed that I’ve gotten quite a few hits through Google looking for data on the Malaysian economy. As a reference point, I’m going to compile in this post the major online-only references that I know of for the basic time series data on Malaysia. If there’s anything readers are looking for that they can’t find, let me know in the comments, and I’ll do my best to oblige. I'd also appreciate it if any broken or wrong hyperlinks are reported.

The one exception to this summary will be historical stock market data, as Bursa Malaysia thinks it can make money off this. In any case, you can get daily KL Composite Index data (from about 1993) from Yahoo! Finance.

I’m listing this by category, rather than by location, as that would probably be more useful. The main sources are:

...although I'm also including some international sources. Most reports are either bilingual (English and Bahasa Malaysia) or English only.

One comment before going forward with the list of references: you can get fairly extended time series through Bank Negara’s online version of the Monthly Statistical Bulletin beyond what’s ostensibly published. From about 2004, BNM published the MSB in both Acrobat Reader and MS Excel formats. In the Excel version, older data points are in hidden columns and rows. Just highlight a whole sheet, right click on a column or row header, and click unhide. In most cases, monthly and quarterly data go back to at least 1998-2000, unless there’s been a change in the price series. For 1996-1997 data, it helps to download the older pdf versions of the MSB circa 1997-1998. Enjoy!

Money and BankingBank Negara’s Monthly Statistical Bulletin (MSB) is available online from the April 1998 issue, with Sections 1 and 2 covering balance sheet items, while Section 4 covers interest rates. Series covered include banking system asset and liabilities, loan direction, loan sectors and purpose, loan disbursements, repayments and approvals, non-performing loans, with breakdowns for commercial (deposit taking) banks, merchant/investment banks, and the now defunct finance company sectors. On the monetary side, series on M1, M2 and M3 plus their components are available. Interest rate series are available for interbank, government securities as well as deposit and lending rates.

Gross Domestic Product (real and nominal)The Economic Planning Unit (EPU) of the Prime Minister’s Department has a summary of GDP tables for annual series (1987 for constant prices, 1947 for nominal prices) and quarterly series (from 2000). Reports are released two months after each quarter end, and are available through DOS (numbers) and BNM (statements). MSB (Section 5) also carries the annual and quarterly series, but not as extensively as EPU.

You can also get both through IMF International Financial Statistics (annual from 1970, quarterly from 1980), plus the volume index which I tend to use as it means you don’t have to deal with the different price bases. IFS is subscription only, but you can get a 5-day free trial which allows full access to the database (discounts available for middle-income countries; free for developing countries). I’d suggest if you’re doing a one-off project like a dissertation or thesis, to register for the trial and download everything.

Annual and quarterly data is also available through the World Bank WDI and IMF World Economic Outlook database, which also have the advantage of carrying PPP-adjusted measures.

Apart from the above, for international comparison purposes, you can also try the Penn World Tables.

Industrial ProductionAs with CPI, initial reports are carried on the DOS website, while time series can be found in the MSB (Section 5). EPU carries longer time series.

Prices (PPI and CPI)First reports for CPI are available from DOS, while BNM’s MSB (Section 5) carries the time series. EPU also carries longer annual series. If you need longer monthly series, I suggest the International Labour Organisation, which provides a linked series across different base years (which saves you the trouble of doing it yourself).

PPI is far more troublesome. First DOS does not issue online reports, while the MSB only carries annual and monthly changes (not the index numbers themselves). In short, you have to reconstruct the index yourself if you use MSB as a source. EPU however does carry the annual index series (and monthly series from 2003), although you’ll have trouble with the fairly frequent change of base year.

Employment/UnemploymentYou’re out of luck.

Employment/unemployment stats have the worst online coverage of any of the major economic statistical categories for Malaysia. DOS carries a monthly manufacturing survey that only covers wages and employment in that sector. MSB is more comprehensive, covering retrenchments, active job seekers and employment offerings by sector, but not an overall unemployment number. The EPU offers annual unemployment statistics, which aren’t terribly useful for current analysis.

PopulationPopulation estimates are available from EPU. DOS also has a population clock on its homepage (MSIE only), with an explanation of the assumptions here.

PovertyPoverty estimates are also available from EPU. Poverty Line Income data however is unfortunately not readily available, nor are income inequality measures. I have a compilation of Gini coefficient numbers lifted from this book, but since I can’t reconcile the numbers with those published in the various Economic Reports, I’d hesitate to place too much reliance in them.

Government FinanceBNM’s MSB, section 6, covers breakdowns of quarterly and annual of federal government revenue sources, expenditure, and composition and holders of government debt. EPU provides annual series going back to 1970, and more interestingly, annual consolidated accounts for the public sector from 1991.

Forex (Ringgit) spot ratesBelieve it or not, the best source I’ve found is the Federal Reserve – they carry daily currency fixes against the USD for a whole bunch of currencies (report H.10*). In the case of MYR, this extends back to 1971. For shorter periods, I use the Pacific Exchange Rate Service, which carries four years of daily data and monthly averages for more extended periods. I find it especially useful since you can download cross-rates directly instead of having to calculate them yourself. BNM also carries daily currency fixes (from 1997), and 3-month and 6-month forward rates (from 1999).

Balance of PaymentsBalance of Payments are reported quarterly. The latest data is available through DOS, and more extensive quarterly and annual series are available from MSB (Section 7). A longer annual series is available from EPU.

International Investment PositionThe IIP is a relatively new metric designed by the IMF to track holdings of foreign assets: don’t expect extensive time series on this. The numbers from 2005 are available from DOS or IMF IFS database.

External tradeThe actual report is issued by MATRADE, which DOS mirrors. Time series and detailed breakdowns are available with a lag through MSB (Section 7) or through EPU. If you need deeper breakdowns, I suggest (unless you want to wade through DOS’ veeerrryy thick annual trade reports) the United Nations Commodity Trade Database. It’s not comprehensive*, but reasonably complete enough for most purposes.

*Like almost all multilateral institutions, the UN doesn’t carry data on Taiwan – an example of politics getting in the way of common sense.

International ReservesReserves are reported biweekly and detailed reports are available from BNM. MSB Section 7 carries the time series.

Miscellanea1. The annually published Economic Reports, prepared in conjunction with the tabling of the government budget, are available through the Ministry of Finance. Extensive statistical tables are available at the back of each edition.

Monday, June 22, 2009

I made a couple of assertions in my previous post that deserve some clarification.

First, I said taking some absolute level of the exchange rate as the equilibrium level, and thus making it the reference point at which you can judge whether a particular exchange rate is “weak” or “strong”, only works if you believe purchasing power parity (PPP) actually holds. Since PPP in its absolute form does not in fact empirically hold, this sort of analysis is inherently flawed. Second, I gave the opinion that since Malaysia appears to be shifting to a deliberate policy of promoting the services sector as the future engine of growth, the exchange rate must necessarily appreciate. These two statements are in fact intimately related, and actually come from the same analytical framework.

To begin, let’s examine the underlying principles of PPP. Take a world with two economic actors and two different currencies– a small open economy (A) and the Rest of the World (B). Only one good is produced and consumed (called W), and that good is globally traded with no friction (i.e. no transport costs, tariffs or taxes). The price of the good is then determined by global supply and demand, and applies to everyone equally (since A is small and thus a price-taker). There are only two factors of production, capital and labour, with constant returns to scale technology and where capital is freely mobile but labour is not. The exchange rate between currencies A and B will simply be the relative price of good W in A and B – in other words, the exchange rate equates the local price of W in both economy A and economy B. That in essence is what PPP says – prices of goods should be equal anywhere in the world after adjusting for the exchange rate. Extend that to the factors of production and in equilibrium, wages and interest rates should also be equal.

Adding complications to this model doesn’t change the underlying principle – trade friction and inflation only adjust the exchange rate required to equalize prices. You can even add stuff like foreign risk premiums or productivity differentials, but nothing fundamental will change – prices should still be equal after these additional costs are taken into account. You can see why PPP is both a powerful and seductive concept: it makes sense, and appeals to people’s sense of symmetry and fairness.

If structural and policy changes to economies happen simultaneously and symmetrically, then absolute PPP will hold – i.e. there is some level of the exchange rate than can be called the relative true value of each currency. If changes do not occur homogeneously, then weak-form or relative PPP will hold – i.e. changes in variables will cause relative changes to the exchange rate. For instance, higher inflation in A would require a weakening of the exchange rate relative to B, but the domestic prices would still equalize to their previous level.

Empirical testing for weak form PPP is thus fairly simple – all you have to do is prove that the real exchange rate (the nominal exchange rate adjusted for inflation) is stationary i.e. it reverts to its previous equilibrium level. Proof for strong form PPP is obtained if the equilibrium level is also equal to unity.*

*If anybody wants to find out how this is done, drop me a line in the comments.

Empirically however, proving PPP has been highly problematical – real exchange rates don’t revert; or if they do, the movement is so slow that it can’t be proven that PPP holds. In fact, most early alternative models of exchange rate determination found little evidence that any single factor actually determines exchange rate movements (e.g. interest rate parity and monetary models).

One possible explanation for the empirical failure of PPP to hold is what’s known as the Balassa-Sameulson hypothesis (henceforth BSH for short). To illustrate the concept, let’s extend our model by adding another good, X, which is produced in both A and B, but is not tradable. The domestic price of X will be determined by local supply and demand, and not at the global level. This implies that the price of X can only be equalized globally under very special circumstances. Why this matters is the impact on the returns to the factors of production – if the price of X is not equalized, then wages cannot also be equalized globally (under the assumption of capital mobility, real interest rates would).

If demand for good X is higher in economy B, then wages would be uniformly higher in economy B relative to A, which reduces the productivity of B in the tradable sector (the production of W) because production costs are now higher - B's supply curve for W shifts left, because of the competition for labour for production of X. Since the supply of W is now lower and wages are higher in economy B, B’s domestic price of W will rise. In response, since PPP still applies to good W, the exchange rate of currency B relative to A must necessarily rise to equate the domestic prices. A will ceterus paribus produce more of W which will be exported to B, producing a trade surplus and a relatively weaker currency for A.

The only point at which the exchange rate would be identical to our first PPP model is if the relative size of the non-tradable sector to the tradable sector in A and B are the same. If they are not, then the equilibrium exchange rate must necessarily be different from the PPP model, and PPP will not hold for all goods and wages.

Here are some of the main implications of BSH:

1. A country with the tradable sector growing faster than the non-tradable sector will have a depreciating real exchange rate, and vice versa;

2. A positive productivity shock in the tradable sector (thus lowering production costs and prices) will result in a weaker real exchange rate, and vice versa;

3. A positive productivity shock in the non-tradable sector will result in a stronger real exchange rate, and vice versa;

4. It is not possible for the absolute form of PPP to apply to all goods, which rules out some notional nominal value of the exchange rate as a permanent, time-invariant equilibrium exchange rate;

5. The equilibrium exchange rate is thus time-varying, depending on the relative strengths of the non-tradable sector in each economy and their growth paths. QED

Thus, when applied to Malaysia, saying for instance that RM2.70 to the USD is the true equilibrium rate for the MYR may have been true in the early 1990s, but is unlikely to be correct now – continuing trade liberalization (which reduces the external price of our tradables), a faster growing tradable sector, and the increasing service sector orientation of the US economy necessarily implies that the equilibrium exchange rate between the MYR and the USD has been falling. In reference to the MYR-USD peg from 1998-2005, BSH also suggests that far from having a “weak” currency policy, Malaysia’s USD exchange rate was actually closing on the equilibrium real rate despite being nominally fixed.

If we consider the multilateral rate (the real effective exchange rate), it’s thus not obvious whether Malaysia ever had a “weak” currency policy that lasted much longer than 1998-2001 – strength in the USD to that point also meant an appreciation of the MYR relative to other floating currencies, which effectively negated any price advantage in export markets and in fact put us at a disadvantage by 2002. To take another example of BSH in action, Singapore shifted to a more service-oriented economy in the wake of the 1997-98 crisis; it is thus no accident that in real terms SGD has appreciated against the MYR since then. BSH also explains why the Indian Rupee continues to have an elevated value, when other metrics suggest it ought to be considerably lower – a strong service orientation as well as relatively high tariff barriers support a more appreciated currency.

This neatly leads into the second assertion in my previous post that I wanted to discuss. The services sector is generally taken to be composed of non-tradables – it is usually difficult to trade services, particularly personal services (the example usually given in text books is that of barbers). Exceptions of course exist, like segments of the transportation sector (port services and airlines for example) or tourism, but generally speaking prices of services are determined mostly by local factors rather than global ones. Thus a future strategy that places the services sector as the engine for growth (as likely to be followed by Malaysia in the coming years), will ceterus paribus result in an appreciation of the true equilibrium exchange rate. Since BNM policy appears to be neutral relative to the level of the MYR (as opposed to its volatility) the nominal rate will also appreciate.

Therefore, a deliberate policy of strengthening the currency to raise domestic incomes is unnecessary – the currency will strengthen anyway with a more services-oriented economy, as local wages are bid up by labour demand from industries which do not suffer from international price arbitrage. Nor is targeting some mythical nominal value of the exchange rate (particularly against the USD) economically sensible or viable – the equilibrium exchange rate can and will vary, depending on the relative balance between the tradable and non-tradable sectors in Malaysia as well as in each of our trade partners.

Of course, evidence of BSH is as hard to find as that of PPP, hence the reason it remains labeled a hypothesis rather than a theory. The main hurdle is fairly simple to articulate but almost impossible to overcome – it is extremely hard to make a distinction between what constitutes a tradable good and a non-tradable good. Government consumption is typically used to proxy the effect of BSH in empirical models, but that is under the (sometimes dubious) assumption that most of government spending falls on non-tradables. Some services sectors are subject to international competition as mentioned before, while most tradable goods contain elements of non-tradable inputs.

Nevertheless, BSH does appear to explain much of why exchange rates tend to persistently resist reverting to PPP values, as well as why some currencies are “stronger” than others. And it also explains why I have no faith in PPP-based judgements of “weakness” or “strength” in any currency.

Saturday, June 20, 2009

etheorist has an interesting post that I’d like to respond to, but since my points won’t exactly fit into a comment box, this post will have to do. I’d encourage anyone to read through the rest of his posts, as together they form a lucid argument for the kind of changes required to transform the Malaysian economy, as well as some of the challenges that need to be overcome. But on this specific post, I have some counter-points that I think need to be laid out.

etheorist puts forth the following arguments:

1. Malaysia has followed a weak currency policy since the 1997-98 crisis, which impacts incomes;

2. Money supply growth has also been excessive since then, with inflation again devaluing real incomes;

3. Loan growth during the same period has been directed more to the household sector, and less supportive of business expansion;

4. Hence, the solution is to support a policy of strengthening the Ringgit over the medium term, which would help improve productivity and real incomes.

I have problems with all four points. First the weak currency policy meme:

The notion that currency values are weak or strong based on nominal relative movements is meaningless outside of a Purchasing Power Parity (PPP) based framework. Exchange rates respond to a variety of influences, which completely overshadow the goods-based price arbitrage that underlies the logic of PPP. There is in fact little empirical evidence that PPP is a relevant metric at all when applied to currency movements. To have a currency falling x% against another therefore isn’t equivalent to it being x% weaker except in a purely market sense – it certainly does not equate to it being weaker from a fundamental economic standpoint.

Another factor to consider is that misalignment in a given bilateral exchange rate does not imply misalignment on a multilateral level. MYR has indeed nominally lost ground against many of the major currencies if you consider pre-1997 levels; but at the same time it has gained ground against many developing country currencies in the same period. From an income standpoint, since most manufactures and resources come from developing rather than advanced economies I can’t buy the argument that purchasing power has necessarily fallen generally.

Moreover, the 1998-2005 USD peg while initially undervaluing the MYR on a multilateral basis in the double digit range post-1998, very rapidly turned into an overvaluation by 2001 making the 2000-2001 pseudo-recession more severe than it should have been. So I tend to discard the idea that there is a deliberate government policy of MYR weakness, particularly with reference to the USD.

I’ll return to the question of weakness/strength of MYR later in this post.

More to the point, etheorist misses one trend that has been crucial in driving banks towards more consumption-based lending – the rise of the PDS market:

To provide some perspective, in 2000-2005 bank lending grew by RM230 billion of which about RM30 billion went to businesses with the rest going to the household sector. Funds raised on the domestic capital markets (debt + equity) during the same period on the other hand was an additional RM133 billion, with a further RM51 billion raised in 2006-2008.

Corporate financing in Malaysia can no longer be characterized as being solely bank-driven – much like more advanced economies, the debt markets have almost completely overtaken that particular role of the banking sector except in supplying credit for smaller companies and to households. Far from being clueless, bankers have responded in a perfectly rational fashion to a secular change in the structure of the economy (and incidentally helped drive the scramble for investment banking licenses). From personal experience, the shift to consumer lending happened as much because of this structural shift as well as the recognition of just how risky business lending was.

Moreover, growth in residential loans, while exceptionally strong in the early part of this decade, hasn’t overtaken incomes or households’ capacity to absorb supply (unlike in the 1990s):

I’m abstracting obviously from changes in income inequality, but the general sense remains true – if lending for housing was truly excessive, price increases should have accelerated faster but they haven’t. So on that score, I’ve little criticism of the changes occurring in bank lending over the past decade.

So where does that leave us? I have no qualms against a stronger nominal MYR – but only where it is strengthening from changes in the economy itself rather than from a deliberate policy shift. Here are my reasons why:

1. The monetary trilemma – you can only control two out of the three monetary policy variables (interest rates, exchange rate, money supply) at any given time. Targeting the currency ala Singapore or Hong Kong means either letting interest rates or the money supply fluctuate freely and with orders of magnitude greater volatility (IIANM Singapore chooses the former while HK chooses the latter). What are the consequences of such a move? Either option means essentially abrogating some control over domestic monetary conditions, which means less influence on credit, growth and inflation. Malaysia has a far bigger and more diverse domestic economy than either HK or Singapore, which implies the negative consequences would be far greater for social welfare – and the negative consequences can be pretty horrible. (Reminder to self: I still owe a blog post on exchange rate regime choices).

2. The causality running between the exchange rate and other economic variables are not necessarily symmetrical or homogeneous. Take for instance productivity – from the Balassa-Samuelson hypothesis, an increase in productivity in the tradable sector (for instance manufacturing) leads to a depreciation of the exchange rate whereas an increase in productivity in the non-tradable sector (for instance wholesale and retail) leads to an appreciation of the exchange rate. On the flip side, I fail to see how an increase in the exchange rate results in any changes to productivity at all.

3. Finally, I believe a deliberate policy of strengthening the MYR is unnecessary and counterproductive – when present policies are leading us there anyway. The shift to a more services-based economy will, like it or not, lead to a general appreciation of the exchange rate without any further action on the part of the central bank. We are no longer in the era of a dirty float regime, with central bank intervention a constant threat over the market. I find little evidence from the data that there has been BNM intervention in the forex market beyond sterilization operations. The movements of the MYR against other true free-float currencies (no, JPY doesn’t count, and USD is really borderline) leads me to believe that we are truly in a managed float regime, as much as that is possible without full convertibility. Intervention will only be contemplated under those circumstances if MYR strays too far from its medium term equilibrium level.

My current view of the MYR is that it is a little overvalued relative to economic fundamentals on a multilateral basis – but not by much. As economic fundamentals dictate (see here for an incomplete list of potential influences), the equilibrium rate will begin rising and we’ll see that stronger exchange rate that everyone seems to clamour for. But that appreciation will be a reflection of the strength of the economy, and not a policy-induced illusion unsupported by real economic factors.

Friday, June 19, 2009

A recent article by Cline & Williamson (2009)* on VoxEU.org investigates the state of play in terms of global currency misalignments, particularly against the USD. The results aren’t too surprising:

“The main counterpart to the overvalued dollar is the undervaluation of the Chinese renminbi, along with a few of the smaller Asian currencies…Our analysis is one more piece of evidence that the major macroeconomic imbalance in the world today stems from China’s exchange-rate policy.”

For the MYR, Cline and Williamson suggest an undervaluation of 17.7% in the real effective exchange rate, and 33.2% against the USD, with a medium term target rate of RM2.63. That’s a substantial movement for MYR, and will have a pretty massive impact on Malaysia’s external demand as well as the current account.

The modeling framework takes its cue from Williamson’s earlier work, which substantially helped launch non-purchasing power parity (PPP) based assessments of exchange rate valuations more than twenty years ago.

Some background is in order here. I’ve posted on these alternative models before, but the model used in this article is a variant of what’s called the Fundamental Equilibrium Exchange Rate (FEER) approach (aka Macroeconomic Balance approach), which uses a medium term current account target as a measure of a currency’s misalignment. Using an elasticity model, the extent of under or over valuation can then be calculated as the movement in the exchange rate required to bring the current account from its forecast level to the model’s target level over the medium term.

As you can imagine, I’m going to pick a few holes in this argument:

1. FEER models have a normative component – the target rate is selected by the researcher (admittedly based on global historical norms), rather than that inherent to each economy. In other words, the extent of misalignment derives directly from what the researcher considers a “sustainable” current account surplus/deficit. For instance, Williamson’s early work used a 2% band rather than the 3% used in the article - a tighter band implies a greater required adjustment. Since the current account covers both trade in goods and services as well as income flows, applying one number to all countries (or even one country at different points of time) isn’t obviously logical. The article attempts to account for this by incorporating a net foreign assets measure where required (essentially replacing a flow variable with a long-term stock variable), but the same critique applies.

2. Secondly, FEER models assume that all adjustments are made solely through exchange rates, which of course isn’t necessarily true. Demand and supply shocks, terms of trade shocks, secular changes in consumer preferences, productivity improvements, changes in portfolio holdings – all can have an impact on the current account without necessarily impacting the exchange rate at all.

3. FEER models don’t incorporate dynamics, which describes the interrelationship between the model variables across time. In short, you know your destination but you have no idea how to get there.

Lastly, I have a procedural criticism – the REERs used as reference points for the article are taken from the IMF International Financial Statistics Database. To my knowledge, the trade weights on these were last changed in 2006 based on averaged trade data from 1999-2001 (and thus accounting for the introduction of the Euro).Ordinarily, I’d have no problem with this as trade weights rarely evolve much in any given 5-10 year span.

In this case however, I think the IMF REER indexes from about 2003 onwards are flawed – the emergence of China has had such far reaching effects on trade patterns that substantial changes in trade weights are warranted. That in turn implies that movements in the IMF REER indexes are too biased towards the G3 currencies, and not enough to emerging markets.

The effective difference doesn’t amount to a lot in an absolute sense – a few points at most on the index scale – but those few points do matter in terms of determining the threshold for possible policy action, and would matter even more if emerging market currencies were more volatile against the USD. In this case, the difference tends to support the article’s primary thesis of USD overvaluation against many Asian currencies.

To illustrate, here’s how the trade weights for the top 5 currencies in my own calculated MYR indexes have evolved during the same period:

Note that there are three different groupings: the EUR has been relatively stable; JPY, SGD and especially USD have been declining; and CNY has been steadily rising, with a big jump in 2003. The IMF static weights for these currencies for MYR are 14%, 15%, 6% (lumping SGD with all other ASEAN currencies), 24% and 5%; the latest weights for mine are 11.2%, 13.5%, 13.2%, 12.8%, and 13.7%. So there have been some pretty big changes in terms of which currencies are more important within a multilateral trade framework.

To illustrate the difference, here’s a comparison of the different indexes:

So, do I believe that MYR is that much undervalued? No, for a few reasons, not least of which are the flaws in the modeling framework I’ve pointed out above. But since this post is getting over long, I’ll save that for later.

Wednesday, June 17, 2009

It’s a topsy-turvy world when an increase in the general price level is cause for celebration, yet that is the stage Malaysia (and the rest of the world) is in now. For nearly forty years, the primary thrust of macro-management has been taming the beast of inflation as the foundation for sustainable growth. Inflation causes many ills, not least of which is devaluing incomes and causing hardship for the poor and the old. But this global recession is unlike any other, with the threat of a deflationary spiral into full-scale depression always present, like a bad party guest who just won’t go away.

For that reason, I wish I could take comfort from the rise in May CPI, but unfortunately I can’t. Disinflation on an annual basis is still ongoing as expected (log annual changes; 2005=100):

But the level of the CPI itself has ticked up:

The source of the rise is what’s causing my discomfort: housing and utilities. While there’s a huge element of subsidy in utilities, I suspect that some pass through of higher energy prices is happening, in which case the rise in the CPI is supply driven rather than demand driven. That means it isn’t caused by the looked-for recovery in consumption that would signal a turnaround in economic activity.

I can’t confirm that of course and it could possibly be due to housing instead, which was potentially boosted as a result of refinancing activities prompted by lower interest rates (the housing component is approximated by rent and imputed rent, the latter of which should be proportional to house prices). That would be better from an economic standpoint, as it implies demand-driven inflation rather than supply-side.

Thursday, June 11, 2009

If it seems I'm slower to blog this month, I spent last week on holiday with my family and the whole of this week on a training course - so time has been extremely limited lately. So this update will be quick and dirty, and focus on the main points of April industrial production for Malaysia.

There were some significant upward revisions in 2009 data that was included with the April release, which served to raise growth rates a few points upwards. Not enough to overshadow the downturn, but does make things seem a tad less bad (log annual changes, seasonally adjusted):

So my call for a bottom to the downturn in April is in little danger (yet). All the indices have stabilised, and in fact we could even say that as far as the main index was concerned, the bottom started in January:

So some encouraging signs at last, though again, recovery is not a foregone conclusion.

Sunday, June 7, 2009

In my post on April trade data I mentioned the potential for the economy moving to a different but lower growth path. While I'm not up to speed on business cycle theory, the genesis for my contention is this 2003 IMF paper* which investigates the response of economic growth to the 1997-98 crisis in a number of countries. The finding was that these economies suffered not just a temporary loss in output, but a permanent loss as well.

This matters because the policy response required is different with respect to the type of recession being faced. But to illustrate the different concepts I'm talking about, the figure below is reproduced from the paper:

To use the terminology of the paper for Malaysia's growth experience, the 1997-98 and 1984-85 recessions were Hamilton recessions, while the 1975-76 and 2000-2001 recessions were Friedman recessions. My guestimate is that the current downturn will turn out to be the former. What's the real difference here?

The normal, Friedman recession is one which is associated with an increase in the output gap, which is the difference between potential output based on labour and capital capacity to produce. The Hamilton recession is where potential output itself is dropping, which signals a permanent loss in output.

While specific policy prescriptions would differ based on the causes of a downturn,in broad terms a Friedman recession only requires countercyclical monetary policy and the automatic stabilizers built into fiscal policy. The fall in growth will be superseded by above-trend growth, which returns the economy back to the former growth path.

The Hamilton recession however requires much more drastic measures, if output loss is not to become permanent. This would necessarily involve more fiscal spending measures, particularly investment which would be needed to replace the capacity loss. Attracting FDI would also help, which can be seen in the experience after the mid-1980s recession (RGDP volume index 1970-2007; log scale):

The trend line indicates the Malaysian economy had a trend growth of 6.44% over the last 35-odd years. However, the slope of RGDP is a little steeper before the 1997-98 recession, which indicates that not only did the Malaysian economy fail to fully recover the output capacity lost at that time, but also failed to attract enough investment to maintain its previous rate of growth. But that's hardly news to anyone.

But perhaps this graph might underscore the seriousness of the current situation, and the necessity of more intervention in the economy (as if anyone needs more ammunition):

This graph shows the weighted average of RGDP per capita against Malaysia's trade partners (2000=100). It's clear from this that Malaysia has continued to lose ground against our trade partners in terms of increasing the welfare and income of our people. And that something more drastic needs to be done to maintain our economic standing in the years to come.

I'm sorry I didn't catch the news sooner: modern econometrics would not be the same without his contributions, and for which he received the Nobel prize in 2003. Most of my masters thesis is based on the techniques developed on Granger's work with Robert Engle. While cointegration analysis has increased in both sophistication and complexity, this essential tool would not have been possible without Sir Clive's insight. Read his obit here.

The Star today has a report on why lending rates have lagged cuts in interbank rates over the past few months. Which is fine - there are indeed good technical reasons for such lags and I've experience enough in the banking industry to readily believe why this is happening.

What isn't explained is why lending rate cuts are also less than the fall in interbank rates. I've covered this topic before, but it bears repeating. Borrowing costs are not fully reflecting the drop in bank funding costs - in effect, banks have increased their margin on lending to the point where the real interest rate (as opposed to the nominal rate) is actually higher now than at the beginning of the downturn:

That makes little sense to me, both from a policy perspective as well as a business perspective. We see here a conflict of incentives that could bite the banks if economic conditions continue to deteriorate. On the one hand, there is the desire to buffer income against the possiblity of loan defaults, which to be fair are likely to rise this year.

On the other hand, higher real interest rates reduces the propensity to borrow and invest, thus reducing the pace and trajectory of potential economic recovery, as well as to increase the systemic probability of the very loan defaults that banks fear. By acting to buffer potential losses, banks may actually be encouraging it to happen instead.

When I did my first evaluation of the Composite Leading Index issued by DOS, it was based on a relatively short sample (from 2005-2008). The results were generally good, with the Leading index approximating movements in real GDP. I've since found a more complete source for the index series, covering 1999-2009. Redoing my forecast models for GDP yielded some disappointing results.

First, fitting the regression became more complicated, with diagnostics revealing serial correlation and heteroscedasticity, which required fitting an ARIMA model (with heteroscedasticity-corrected standard errors) to the data rather than a purely deterministic one. Second, while the Leading Index showed a good fit for most of the sample, the relationship basically breaks down right at the beginning of the downturn in 2008:4. The following shows the model using seasonally adjusted rGDP:

In both models, the residual breaks sharply from the standard error line, which represents about 70% of probable observations assuming a normal distribution. The seasonally adjusted model indicates that the fall in 2009:1 rGDP was a 4 standard error event (a probability of 0.003%), while the seasonal dummy model indicates a 2.8 standard error event (a probability of 0.2%).

In short, this downturn is something out of the ordinary even for a recession. The Leading Index is in fact currently out of step with the economy, and would overstate GDP if used as a basis for forecasting. In comparison, the residual in the short 2000 recession was barely out of the 1 standard error line, and that only in the second model.

To be fair, the Leading Index is not constructed as a direct representative of movements in GDP, but rather an indicator of turning points in economic activity. Also, my data only covers from 1999-2009, which really is just one full business cycle. On that basis, there may be some hope that the DOS forecast of a turnaround in the economy in 2009:3 may come true. But I'm not holding my breath.

Saturday, June 6, 2009

There have been tentative signs of improvement in the economy, but April's trade data offers to my mind the first real confirmation of stability. Although February trade spiked up, that was largely to me an inventory spike. Growth rates for April are still horrible (log annual/monthly changes):

But actual volume has leveled off for exports and improved in the case of imports (seasonally adjusted):

Especially encouraging is the month on month growth in intermediate goods imports, which would help determine future exports (log monthly changes):

To underscore this point, my forecast models are both pointing up (I'm abandoning the probability based ARMA model for now):

The seasonal adjustment model is still under-forecasting actual performance to the tune of RM5.6b, but the seasonal effect model remains close at under RM2.9b. May exports forecasts for my two remaining models are:

We're still going to see sharp declines in terms of growth rates, but month on month data should continue to see some improvement. While the empirical evidence is till shaky, I wouldn't hesitate to call a bottom to the downturn for now.

The big problem of course is that stability does not equate to recovery, much less a return to our previous growth path. The 1997-98 crisis caused many of the effected economies (including Malaysia's) to move to permanently lower growth paths, rather than a return to the previous one. While the external genesis of this downturn suggests the latter is at least a possibility, there are too many uncertainties to make that kind of determination yet.

Technical Notes:Trade data from Matrade. Details on the construction of my export forecast models are available here.

Friday, June 5, 2009

There's been a lot of talk in the press about a new economic model for Malaysia, and it isn't just a reaction to the present economic downturn we are facing. On a subjective level, the emergence of China as the world's factory has created a formidable competitor in manufacturing, but even here China is being superseded by Vietnam and Mexico in low-cost production. So there's been a lot of changes internationally in the last decade that put's into question Malaysia's development strategy. There's been an obvious impact in terms of trade and manufacturing numbers that help outline these trends.

Also while the share of total trade to GDP has been rising to a truly astounding level (+200%) the direct contribution of trade to growth has been negligible. I haven't fully worked out the indirect impact however, which ought to be substantial given the reaction of the economy to the deterioration of global trade this last 9 months. Nevertheless its interesting to note the evolving contributions to growth on the expenditure side:

1987-2000

2000-2008

Total Consumption

52.6%

91.2%

Government Consumption

9.1%

21.3%

Private Consumption

43.5%

69.9%

Gross Fixed Capital Formation

36.3%

16.6%

Net Exports

9.2%

1.4%

Between 1987 and 2000, the economy grew 159.7%, even with the recession of 1997-98. Out of that growth, just over half came from public and private consumption, while a further third came from investment. In contrast, the growth contribution of consumption for the period 2000-2008 exceeded 90% even if the share of consumption (<52%) is below the average for industrial economies, and the economy only grew 48.4%. In both cases, the direct growth contribution from trade was relatively minor.

So what's next, if manufacturing (on the supply side) and trade (on the demand side) are no longer the key drivers for growth? Quah Boon Huat of MIER outlines my own particular viewpoint of how the Malaysian economy ought to evolve:

“This change in policy focus on the services sector is not an unreasonable strategy shift considering that Malaysia will have trouble maintaining its growth momentum, going forward, if it were to continue relying on an export-led growth strategy that is primarily dependent on manufacturing. The strategy is after all already well past its sell-by date for Malaysia. This is because rising competition from regional powerhouses, China and India, countries that have significant competitive advantages in manufacturing, will see to that. “

I've been preaching a strategy shift to services sector growth for a few years now, but there is in fact little empirical backing for such a move. In fact the debate is still open when it comes to the determinants of economic growth. You could say that the warring camps on the appropriate policies and timing of development is really an argument on the level of theology rather than science – it takes a leap of faith.

There have been many alternative suggestions to getting Malaysia over the middle-income hurdle from a strong Ringgit policy, to raising real incomes, to promoting a consumption based economy.

The problem from an economic planning perspective is that there's very little in terms of solid guidance on what would constitute the right way forward. Every country's capabilities and resources are different; legal and judicial frameworks differ; culture, education and institutions don't work exactly alike. What works for one country may not necessarily work for another. Initial conditions matter in terms of reaching a particular level of development, and so does the timing of institutional development and reform. The social, political and economic chaos attendant to Eastern Europe's (and particularly Russia's) shift from centrally planned economies to market economies provides a strong counter argument against going cold turkey.

The literature on economic growth also provides little comfort, at least to my mind. Solow's seminal attempt at quantifying economic growth (after accounting for labour and capital inputs) resulted in the conclusion that technological progress was the key driver of growth. But empirical evidence in support has been largely contradictory and isn't a great deal of help in formulating a development strategy.

Looking at past history, using the experience of other countries as 'natural experiments', leads to the structural view of development. This viewpoint suggests that economic development on the supply side follows a defined path: exploitation of natural resources->processing->heavy industry->services-based development. On the demand side, the equivalent path is net exports->investment->consumption. The reality is more nuanced than that of course, but I find this useful as shorthand in explaining economic development.

I'll forbear from discussing all the possible pitfalls of implementing services based development – education, culture, etc. These have been discussed ad nauseum elsewhere and in better detail. What I would like to mention is some of the possible ramifications of services-led growth. First is that since wages in the services sector are less subject to international arbitrage than in the tradable sector, real incomes would tend to rise under this strategy. This in turn implies a greater share of consumption in GDP, as well as a stronger exchange rate. Services-led growth therefore rather neatly encompasses quite a few of the alternative strategies I mentioned.

One issue that does worry me though is that the services is a catch-all label for a number of very different industries, from government to finance to tourism, to everything in between; development policy as a result would have to be necessarily fragmented. And Quah's concern about neglect of other sectors is very real and.pertinent. Investment in services should not come at the expense of maintaining our competitive position in other sectors, particularly agriculture and manufacturing.

Why should we bother if China is so far ahead in manufacturing and India in services? Because the principle of comparative advantage suggests that even if we cannot compete on price, scarcity of resources and specialisation of production means that there will always be a niche to be filled. On that basis, we should not over-pursue development in any one particular sector – while a simplistic, focused strategy is probably easier to sell to the public and to implement, it does not make economic sense in terms of maximising welfare.

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About Me

An applied and practicing economist in the Malaysian financial sector.

The purpose of this blog was first to have a way to put down and present my ideas, work in progress, and thoughts on the Malaysian economy. The second reason was to hopefully attract critiques and feedback, that would help me improve on my own understanding of the way the world works, or at least, this little corner of it.